Has DreamWorks Lost the Plot?

Disappointing earnings and sinking stock are fueling speculation that the studio could be a candidate for acquisition

Where's a big, green ogre when you need one? That's probably what shareholders in DreamWorks Animation (DWA) are wondering these days. The 10-year-old animation studio, launched by Hollywood titans Jeffrey Katzenberg, David Geffen, and Steven Spielberg, is at least one Shrek short of a hot streak.

Weighed down by last year's less-than-spectacular film Wallace and Gromit: the Curse of the Were-Rabbit, the studio reported on May 2 that its first-quarter earnings had tumbled to $12.3 million, from $45.7 million a year earlier. Revenues fell to $60.1 million for the period, from $167.0 million the year before, when it was riding the hefty sales of DVDs from its blockbuster film Shrek 2.

Wall Street hasn't expected much from DreamWorks for much of the last year. The company first disappointed analysts a year ago when it misjudged the number of Shrek 2 DVD units it would sell -- and then missed its own optimistic assessment of how its film Madagascar would do last summer. All that has raised concerns among some financial analysts about its prospects, with the stock falling over the past year from $38 a share to $26. It dropped 75 cents, or 2.8%, on May 2 in anticipation of the earnings announcement after the market's close. In after-hours trading, shares recovered most of that decline.


  Now DreamWorks is a stock in search of a catalyst, be it a hot flick or a sale. It increasingly looks as if its upcoming film Over The Hedge, to be released on May 19, may not be enough. The film played well for movie theater owners at the recent ShoWest gathering of Hollywood and theater owners, but it faces hefty competition from heavyweight films. Fox (NWS) plans to release X-Men a week later and the much anticipated Cars from Pixar (PIXR) is scheduled to debut on June 19. "It's a very competitive time to be releasing a film," said DreamWorks Animation President Lewis Coleman. "So we'll all be watching closely to see how it holds up among the other releases."

Guessing film performance can be difficult at best. Analyst Jessica Reif-Cohen of Merrill Lynch (MER) expects that Over the Hedge will gross $195 million in the U.S. and about $420 million worldwide, about what Madagascar did last year. But DreamWorks won't likely see a lift until later this year when the film starts to sell as a DVD, figures Reif-Cohen. DreamWorks isn't getting much in the way of revenues this year from its most recent release: Wallace and Gromit grossed $56.1 million in the U.S. and hasn't sold well as a DVD, saddling DreamWorks with a $29 million write-down, figures Pali Research analyst Richard Greenfield.

Greenfield figures there's a bigger shock coming for DreamWorks' shareholders. He put a sell recommendation on the stock on May 2, before the earnings announcement came out. The reason? Under the shareholder rights agreement that DreamWorks has with Paul Allen, the Microsoft co-founder and a large investor in DreamWorks, Allen can force the company to sell more stock in a secondary offering starting June 1. Greenfield predicts that "a $326 million secondary offering will likely occur on or shortly after June 1, 2006" so that Allen can recover some of the $707 million that he invested in the company. That would likely depress the stock further. Greenfield figures that the stock will fall to around $22 on the basis of tough comparisons with prior years and the secondary offerings.


  All of which makes for lively Hollywood chatter that DreamWorks may be headed for an acquisition. The most likely acquirer is Viacom's Paramount Pictures, which late last year spent $1.6 billion to buy DreamWorks' live action business. DreamWorks has no comment on the rumors, and its low stock price makes some on Wall Street figure any deal is unlikely until the next Shrek comes along in 2007.

Still, Paramount would in fact make a great acquisition partner. As part of its deal to buy DreamWorks' live action business, Paramount already has the right to distribute Dreamworks animation films and DVDs. And Viacom is gearing up to promote Over the Hedge with its Nickelodeon cable channel, says Coleman, the DreamWorks' president. Paramount may be willing to step up with an acquisition offer to share in all of the company's profits, instead of the 8% fee it gets from distributing DreamWorks' flicks now, figure many in Hollywood. DreamWorks' market cap is about $2.7 billion.

The amigos who started DreamWorks in 1994 may not want to think about that deal for now. They have high hopes for Over the Hedge, and perhaps for Flushed Away, -- their next film, due to be released in November. That flick, however, is being produced by the Aardman Animation studio in England, which produced Wallace and Gromit, DreamWorks' worst film to date. Even by Hollywood standards, DreamWorks will need a dramatic ending to persuade Wall Street of its prospects for a turnaround. The studio desperately needs the big green fella to show up quickly.

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